"Getting to the Source: Analyzing Recent Sourcing Updates," - PICPA's CPA Now

Sourcing income is a challenging aspect of tax compliance for businesses operating in multiple jurisdictions.

Look-Through or No Look-Through?

To accurately determine a customer’s location under market-based sourcing, it is important for tax professionals to understand who the customer is. What may have once seemed to be a simple exercise in determining a “customer” has proven to be a complex area of increasing litigation. In the first major sourcing case, the Ohio Supreme Court found that the customer of a taxpayer who sold security monitoring service contracts to Ohio consumers on behalf of an alarm service company was the alarm service company itself, not the Ohio consumers.¹ Similarly, in LendingTree LLC v. Dept. of Revenue, lenders paid LendingTree for referrals to prospective borrowers. LendingTree sourced its receipts to the location of its customer, the lenders, but the department argued the receipts should be sourced to the location of LendingTree’s customer’s customer – the prospective borrowers. The Washington Court of Appeals disagreed with the department and reasoned that the benefit of LendingTree’s service was received at the lenders’ business locations, not the location of the prospective borrowers.² Finally, in Walter Dorwin Teague Assocs. Inc. v. Dept. of Revenue, the taxpayer designed aircraft interiors for Boeing, who would then manufacture the aircraft using the taxpayer’s designs and sold the aircraft to various airlines. The taxpayer argued that it should source its receipts to the airlines, its customer’s customer, but the Department of Revenue disagreed. The Washington Court of Appeals found that receipts should be sourced to the location of Boeing, the taxpayer’s customer, because the benefit was received at Boeing’s manufacturing location, not where the planes were ultimately used.³

These early decisions from Ohio and Washington seemed to agree that receipts should be sourced to the locations of the taxpayer’s customers, not a look-through approach to the taxpayer’s customers’ customers that was championed by the states. However, more recent decisions have accepted a look-through approach. For instance, in Express Scripts Inc. v. State Tax Assessor, the taxpayer sold prescription drugs by mail order to insurers, employers, and health plans (taxpayer’s customers).⁴ Express Scripts’ customers then dispensed the prescriptions to their plan members (taxpayer’s customers’ customers). The Maine Supreme Court sourced the receipts to the plan members (taxpayer’s customers’ customers). The court reasoned that the service was received at the plan members’ location and focused on statements in the taxpayer’s 10-K, which stated, “Express Scripts provides services to members of the affiliated health plan.” The 10-K is used for annual reporting purposes to detail the company’s business and financial condition. Practitioners and taxpayers should be aware of the court citing the 10-K since most businesses do not consider the state and local tax implications of statements made on a 10-K.

What Is the Income-Producing Activity?

To further complicate sourcing rules, while many states have adopted identical or near-identical language as found in the Uniform Division of Income for Tax Purposes Act, some states do not use the typical statutory language. For instance, South Carolina focuses on the “income-producing activity” without the additional “cost of performance” statutory language, and its courts have determined that the state is neither a “cost of performance” nor “market-based sourcing” state. This has led to a number of issues between the state’s Department of Revenue and taxpayers regarding how to properly source receipts.

Most recently, in Mastercard International Inc. v. Dep’t of Revenue,⁵ the international credit card network argued that its income-producing activities take place at its two data centers located in Missouri or at the locations of its servers running its proprietary software. Conversely, the department of revenue argued that Mastercard generates income by charging transaction processing fees and ancillary value-added services within its network – thereby sourcing receipts to South Carolina when a transaction is initiated in the state because that is the location of the “income-producing activity.”

In agreeing with the department, the court explained that Mastercard’s income-producing activity is generated by charging fees based on the number of credit and debit transactions using Mastercard-branded cards and the gross dollar volume of those transactions. When cardholders present a Mastercard-branded card to pay for goods or services, the transactions are initiated. The court reasoned that these transactions are only possible because of the payment system that MasterCard created, which is present in South Carolina.

In U.S. Bank v. Dep’t of Revenue,⁶ the court found that the taxpayer should source certain mortgage and credit card related interest and fees to South Carolina because the borrowers are paying for the use of the bank’s funds to “purchase and/or improve real property located in South Carolina,” and the credit card activities and merchant fees generate income when the credit card holders use the cards in South Carolina. Both cases are currently under appeal.

The sourcing of receipts has become an increasingly contentious issue between states and taxpayers. Practitioners should continue to monitor developments in this area.

¹ Defender Security Co. v. McClain, 165 N.E.3d 1236 (Ohio 2020).
² LendingTree LLC v. Dept. of Revenue, 460 P.3d 640 (Wash. App. 2020).
³ Walter Dorwin Teague Assocs. Inc. v. Dept. of Revenue, 500 P.3d 190 (Wash. App. 2021).
⁴ See Express Scripts Inc. v. State Tax Assessor, 304 A.3d 239 (Me. 2023).
⁵ Mastercard International Inc. v. S.C. Dep’t of Revenue, No. 20-ALJ-17-0008-CC.
⁶ U.S. Bank N.A. v. Dep’t of Revenue, S.C. Admin. Ct., No. 20-ALJ-17-0168-CC.

This blog originally posted on the PICPA’s CPA Now blog in January 2025. Access the article online here.